The Altman Z score combines five weighted ratios, covering liquidity, accumulated profits, profitability, market value against debt and asset turnover, into a single number intended to separate companies that look like past failures from those that do not. In the version taught by ACCA, a score above 3 is treated as safe and a score below 1.8 signals a risk of failure within two years. It was built on listed American manufacturers, so it fits UK small and private companies poorly and should be used as a screening tool, not a verdict.
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What is the Altman Z score and where did it come from?
E.I. Altman published the model in 1968. A Bank of England discussion paper by D.A.J. Marais (1979) describes how it was built: Altman examined 22 financial ratios for 33 American manufacturing companies that failed between 1946 and 1965, and compared them with 33 companies that had not failed, matched by time period, industry and asset size. Using a statistical technique called discriminant analysis, he selected the five ratios and the weightings that best separated the two groups.
It has lasted. A 2022 Bank of England staff working paper calls the Z score arguably still the most widely used measure of corporate financial distress and a benchmark against which other measures are judged.
How is the Z score calculated?
The formula, as set out in the Bank of England working paper and in ACCA’s Advanced Performance Management specimen exam, is:
Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5
| Ratio | Calculation | What it captures |
|---|---|---|
| X1 | Working capital / total assets | Short term liquidity |
| X2 | Retained earnings / total assets | Accumulated profitability and age |
| X3 | Earnings before interest and tax / total assets | Current earning power |
| X4 | Market value of equity / book value of total liabilities | How far value could fall before debts exceed it |
| X5 | Sales / total assets | Asset turnover |
Sources differ on X4. The Bank of England paper uses book value of total liabilities, while the ACCA specimen exam defines it as market value of equity over total long term debt. Check which denominator a published score used before comparing it with your own.
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What do the scores mean?
ACCA’s specimen exam states that a score of more than 3 is considered safe and a score below 1.8 means the company is at risk of failure in the next two years. Scores between the two fall in neither band and call for further analysis.
Three cautions apply. First, the Marais paper notes that Altman’s model worked fairly well in the last two years before failure, but by the third year its predictive accuracy fell off dramatically. Second, the same paper warns that a low score does not mean a company will fail, only that it shows characteristics similar to past failures, so no decision should be taken without closer analysis. Third, it recommends looking at the trend in scores over the last few accounting periods, because a steady decline suggests a higher probability of failure. That makes the Z score a natural companion to horizontal trend analysis.
What does a worked example look like?
Illustration only. A listed company has total assets of £10m, working capital of £1.5m, retained earnings of £3m, EBIT of £1.2m, a market value of equity of £6m, total liabilities of £5m and sales of £15m.
| Ratio | Value | Weight | Contribution |
|---|---|---|---|
| X1 £1.5m / £10m | 0.15 | 1.2 | 0.18 |
| X2 £3m / £10m | 0.30 | 1.4 | 0.42 |
| X3 £1.2m / £10m | 0.12 | 3.3 | 0.40 |
| X4 £6m / £5m | 1.20 | 0.6 | 0.72 |
| X5 £15m / £10m | 1.50 | 1.0 | 1.50 |
| Z score | 3.22 |
The company sits just inside the safe band. If EBIT fell to £0.2m, X3 would contribute only 0.07 and the score would drop to about 2.89, into the grey area, even though nothing else changed. Notice also that asset turnover supplies nearly half the score. A business with few assets and high sales, such as a staffing agency, can score well while being thinly capitalised, and a property heavy business can score badly while being sound. That is a consequence of the original manufacturing sample, not a finding about the business in front of you.
Why is the Z score hard to apply to small and private UK companies?
No market value. X4 needs a share price. In a model answer on a comparable failure prediction score, ACCA notes that a model requiring the market value of equity cannot be applied to a privately owned company. Substituting book value is common, but the weights and cut offs were estimated on market values, so the result is no longer the model that was tested.
Missing figures in filed accounts. Under section 444 of the Companies Act 2006, a small company must deliver its balance sheet to Companies House but need not deliver its profit and loss account, so EBIT and sales (X3 and X5) are often unavailable. The micro entity balance sheet format in Section C of Schedule 1 to SI 2008/409 shows capital and reserves as a single heading, so retained earnings (X2) may not be visible either. Companies House said on 23 October 2026 that it has paused the plan to make small and micro companies file a profit and loss account from April 2028, so filleted accounts will continue. See reading a company’s accounts from Companies House.
A different population. ACCA’s specimen answer points out that the model was developed in the late 1960s on US companies and the world economy has changed significantly since. Marais judged Altman’s ratios impractical to test on UK data at the time, in particular retained earnings to total assets, which Altman regarded as the single most important ratio. A 2003 Bank of England working paper on UK business failure notes that models based on market prices can only be applied to quoted companies, just over 1,000 of the 1.6 million registered UK companies; that accounts become increasingly incomplete as firms get smaller; and that firms with fewer employees are more likely to fail.
Backward looking. ACCA’s model answer also stresses that such scores are a measurement at a single point in time, built from historical data, and only relevant if the company resembles those used to build the model. The 2022 Bank of England paper found the Z score added little once other market based measures and controls were included in its tests.
What should you use alongside it?
For a small private company the better starting points are the two statutory insolvency tests, a cash flow forecast, and the directors’ going concern assessment. Individual ratios such as the current and quick ratios and interest cover tell you which part of the business is under strain, which a single composite score cannot. ACCA’s examiners also expect qualitative failure models, such as the Argenti model, to be weighed against quantitative ones like the Z score rather than relied on alone.
What mistakes come up most often?
- Applying the original weights and cut offs after replacing market value with book value.
- Comparing scores calculated with different definitions of X4.
- Reading a single year’s score instead of the trend over several years.
- Treating a score below 1.8 as proof of insolvency, or a score above 3 as proof of safety.
- Guessing missing profit and loss figures from filleted accounts and presenting the result as reliable.
- Using the model on service, retail or property businesses without allowing for the effect of asset turnover.
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Related Accountapedia entries
- Financial covenants in bank loans
- DuPont analysis of return on equity
- Weighted average cost of capital (WACC)
- Return on capital employed (ROCE)
- Net profit margin
Sources
- Bank of England: A method of quantifying companies relative financial strength
- Bank of England: Chronicle of a death foretold does higher volatility anticipate corpor
- ACCA: S19 Specimen Paper APM
- ACCA: S18 APM Ans Clean Proof
- ACCA: 1210 p5
- Bank of England: Company accounts based modelling of business failures
- legislation.gov.uk: Act 2006 c. 46, section 444
- legislation.gov.uk: SI 2008/409, schedule 1
- GOV.UK: Companies house to bring in changes to accounts filing from april 2028
Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 19 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.